If you’re reading this article, you’re very likely in one of two situations: either you already have an interest in a foreign corporation and you’re trying to understand your reporting obligations to determine what you need to do // if you’ve been reporting this interest correctly, or you are considering acquiring an interest in a foreign corporation and you want to weigh the pros and cons of that interest. If it’s the former, I’m sorry that you find yourself in this situation and that no one advised you on the excessive reporting obligations and the large penalty exposure for inadequately doing that reporting. If it’s the latter, now is the time to come to understand the applicable reporting obligations and potential penalty exposure to make an informed decision as to whether acquiring this interest is worth the expense and exposure.
This article is going to serve as an overview of some of the concerns applicable to individuals with interest in foreign corporations and a number of more detailed articles will spring from the topics introduced in this article.
Form 5471
Form 5471 has five categories of filers and there are a number of different relationships with foreign corporations that can give rise to a Form 5471 filing obligation. These obligations are very technical and there are a lot of potential ‘gotcha’ issues that can result in filing requirements that you may have reasonably believed didn’t apply. If you’re in any way uncertain if your situation gives rise to reporting obligations, please, reach out. So long as the IRS hasn’t acted yet, you will have several options in correcting your filings.
Category 1 is the newest category, created in its current incarnation through the major tax reform during 2017, and applies to U.S. shareholders that have an interest in a “Specified Foreign Corporation.” Unfortunately this form is absolutely packed with technical terms that have specific meanings, terms that make it very difficult for individuals to understand their reporting obligations without going down countless rabbit holes to understand these terms. “Specified Foreign corporation” is a term relating to the 965 transition tax, but for our purposes here, you need to know that you are likely a category 1 filer if you are a category 5 filer and being a category 1 filer isn’t going to meaningfully increase your reporting obligations aside from the impact of the transition tax as applied to the 2017 tax year of the foreign corporation.
Category 2 applies to a U.S. person that is an officer or director of a foreign corporation that has had any U.S. person acquire a 10% (or an additional 10%) ownership interest in that corporation. Let me emphasize ‘any U.S. person’, the individual that is the officer or director does not have to personally acquire any interest in the corporation to give rise to this reporting obligation. Category 2 is a transactional filing requirement. This means you have to complete the required Form 5471 schedules for category 2 filers for the year during which the transaction occurs that gives a U.S. person the 10% or additional 10% ownership interest.
Category 3 applies to a U.S. person that acquires a 10% or more interest in a foreign corporation. Like category 2, category 3 is also a transactional filing requirement, but for category 3, we are only concerned with the ownership interest of the individual (this will include constructive ownership, an issue we will have to dive into in a different article that is coming soon). Note that either acquiring the 10% or more interest OR becoming a U.S. person when you already own the 10% or more interest can give rise to this reporting obligation.
Category 4 is for a U.S. person who has ‘control’ of a foreign corporation. Unfortunately, thanks largely to constructive ownership and indirect ownership concerns, this category of filer is not as straightforward as one might believe. For most individuals, if you own more than 50% of a foreign corporation, this category and as a result most of the Form 5471 schedules, need to be completed. I will get into more detail on constructive and indirect ownership in a later article, but if you have an interest in a corporation and you have a relative with an interest in that corporation, you need to learn more about constructive ownership. Alternatively, if you have in interest in a business entity…. that has an interest in another entity, you need to be concerned with the implications of indirect ownership.
Category 5 is for individuals that are ‘shareholders’ of ‘CFCs’. Here, shareholder means a U.S. person that owns 10% (again directly, indirectly, or constructively) of a foreign corporation and CFC means controlled foreign corporation, which is a foreign corporation that is more than 50% owned by ‘U.S. shareholders’. Category 5 is the category that results in you having to pay tax on the income of your foreign corporation annually, regardless of whether that income is actually distributed to you (GILTI and Subpart F).
Form 926
This is the form you need to report any transfers to your foreign corporation. I’ve had a lot of clients that conduct their corporation’s business through their personal bank accounts. This is a mistake that results in a considerable amount of 926 reporting annually. It converts every expense you pay to a ‘transfer to a foreign corporation’. Of course there are times when your business may need an infusion of capital, and these infusions are tracked by and reported on Form 926. When cash or other assets leave your pockets or your accounts and go into your foreign corporation, you need to file Form 926.
Form 8938
Your ownership of a foreign corporation counts towards your Form 8938 filing thresholds. This is a strange filing requirement and an infuriating method for the IRS to apply another $10,000 penalty. If your interest in a foreign corporation is your only foreign asset, it’s entirely possible that putting a ‘1’ on the Form 5471 line on Form 8938 Part IV may satisfy your Form 8938 reporting obligation. It is also worth mentioning that your ownership of shares of a foreign corporation, even when this ownership isn’t significant enough to give rise to a Form 5471 reporting obligation, can still create a Form 8938 obligation (whether the shares are held in a foreign investment account or the share certificates are held directly) See this article on Form 8938 for more detail on that form.
FBAR - Report of Foreign Bank and Financial Accounts
Does your foreign corporation have any foreign accounts? Well, these accounts need to be captured on your FBAR. A lot of people think- well, these aren’t my accounts, they are company accounts, so I shouldn’t have to put them on my FBAR. This is dangerously incorrect. You likely have ‘signatory authority’ over the accounts held by your foreign corporation, but, even more importantly, if you own more than 50% of the corporation, you also have a financial interest in these accounts. We see this reported incorrectly on FBARs often. See this article for more information on FBARs.